Google, efficient markets and box lunches with Bill Sharpe

CAPM / Alpha Theory 09 Apr 2008

Much of the focus of this website is institutional (pensions, endowments, portable alpha etc.).  But many readers are also financial advisors who realize that many of the ideas adopted by institutions eventually make their way to the world of retail investments.  If you are such advisor, there is one online publication to which you should really subscribe: Advisor Perspectives.  This weekly e-newsletter often contains some interesting commentary on active and passive management – the retail version of many of the alpha/beta concepts discussed here.  Best of all, it’s free.

This week, it contains an interesting piece by a fee-only portfolio manager that recounts the story of how the founders of Google educated their soon-to-be rich pre-IPO employees on how to stay rich post IPO.  But while the story is presented as an endorsement of efficient markets, it may actually raise as many questions as it answers about the battle between active and passive management.

Says the article:

“As described in a well-written San Francisco Magazine article [ed: link], Google founders Page and Brin facilitated a series of investment lectures to their legion of employees prior to Google’s historic 2004 public stock offering. With the usual sharks of Wall Street circling—hoping to sink their teeth into the hundreds of soon-to-be multimillionaires—the Google founders instead brought in the most revered names of financial academia to teach the company’s brilliant engineers, programmers and web-geeks the art and science of personal investing.

“First to arrive was 1990 Nobel Laureate Bill Sharpe. Rather than dazzle the crowd with the finer points of portfolio optimization or his Capital Asset Pricing Model, Sharpe instead offered a simple recipe for a lifetime of investment success: Don’t try to beat the market. Instead, put your savings in a few diversified index funds and let capitalism and the efficient market work for you. The following week’s lesson was taught by Burton Malkiel, finance professor at Princeton and author of A Random Walk Down Wall Street: Don’t try to beat the market, he said, and don’t believe anyone who says they can—not a friend, a broker with a hot stock tip, or the latest magazine touting the most recent outperforming fund.”

William Sharpe is often cited in articles attacking active management.  To be sure, Sharpe is definitely a skeptic of active investing.  But he actually leaves the door open to active management and even the possibility of out-performance by certain segments of the investing population.

In his seminal 1991 article for the Financial Analysts’ Journal about efficient markets, he states the obvious, if overlooked, axiom of active and passive management:

“Over any specified time period, the market return will be a weighted average of the returns on the securities within the market, using beginning market values as weights. Each passive manager will obtain precisely the market return, before costs. From this, it follows (as the night from the day) that the return on the average actively managed dollar must equal the market return. Why? Because the market return must equal a weighted average of the returns on the passive and active segments of the market.”

In other words, the universe of active managers will necessarily produce the market return on average – since they are the market.

However, later in the same essay, Sharpe also states that:

active managers may not fully represent the “non-passive” component of the market in question. For example, the set of active managers may exclude some active holders of securities within the market (e.g., individual investors). Many empirical analyses consider only “professional” or “institutional” active managers. It is, of course, possible for the average professionally or institutionally actively managed dollar to outperform the average passively managed dollar, after cost. For this to take place, however, the non-institutional, individual investors must be foolish enough to pay the added costs of the institutions’ active management via inferior performance. [our emphasis]

You don’t have to look too hard to find examples of individual investors being foolish enough to pay the added costs ofinferior performance.  If non-economic motivations of some market participants are a prerequisite for alpha generation (e.g. inventory hedging for institutions), then brand loyalty (via marketing) is surely enough to retard the free flow of retail capital and therefore allow certain other investors to generate persistent out-performance.

Since the advent of the CAPM, academics have gradually eschewed perfect markets in favour of the semi-efficient variety.  In an interview with last year, Prof. Thomas Schneeweis, editor of the Journal of Alternative Investments said:

“The CAPM was devised in 1964. But by the time I got my Ph.D. in the 1970s, we knew that model was not really measurable. It’s amazing how long it’s lived on. Now, we academics don’t even talk about efficient markets any more.”

In his recent book (see review) Sharpe goes beyond the one-size-fits-all approach of the CAPM and suggests that the appropriate portfolio for each investor depends on their unique profile.  This suggests a hetergeneity of investors that adds new complexity to the homogeneity assumptions underlying efficient markets.

Sharpe even acknowledged the potential value of active management during an interview with Advisor Perspectives last fall:

To find superior managers, you must look for those with some degree of flexibility. But, in doing so, you will undoubtedly find some managers that are inferior. To beat an index you can’t be too close to it, but that is not a guarantee that you will succeed. Whether managers should get a broader mandate depends on their knowledge of the markets. If a manager is hired, for example, to manage large cap growth stocks, and that is the manager’s realm of expertise, you don’t want that manager deviating from this charter. There is a limit to the amount of information a manager can gather and process. Technology helps in this respect, as does ‘feet on the ground’ (e.g., visiting companies and speaking with management). [our emphasis]

So it appears Sharpe may not have been the staunchest advocate of efficient markets that Sergey Brin and Larry Page could possibly have come up with for their soon-to-be-rich employees.  But who cares?  After all, the guys brought in Bill Sharpe for a company lunch-and-learn for goodness sake!  They might as well have also brought in the President for some tax planning advice and the Pope for a self-improvement seminar.

The fact remains: if there’s no such thing as a free lunch, then what did the Google employees eat as they listened intently to Bill Sharpe’s ruminations on how to stay rich?

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